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A U.S. District Court issued a ruling on March 28 that affects pension liabilities for private equity funds and their portfolio companies. Taken further, the ruling potentially changes fundamental rules for tax-qualified plans in determining how far a controlled group of employers may extend.

The Takeaways:

Two or more related private equity funds could be treated as collectively liable for a portfolio company’s pension liabilities if the arrangements appear to have been coordinated to avoid responsibility for the pension liabilities—even if neither fund owns 80% of the portfolio company.

Related private equity funds should be reviewed if the funds could be combined for controlled group purposes.

The Case:

The case is Sun Capital Partners III LP v. New England Teamsters & Trucking Industry Pension Fund, (2016 BL 95418, D. Mass., No. 1:10-cv-10921, 3/28/16). The primary issue in the case was whether private equity funds were engaged in a trade or business, such that they might be responsible for a controlled portfolio company’s pension liabilities (which in this case were multiemployer pension fund liabilities). The bankrupt portfolio company in this case was owned by two related private equity funds. The appellate court had determined that the 70% owner was engaged in a trade or business, and remanded the case to the district court to determine whether the 30% owner was engaged in a trade or business. The district court determined that it was. The court applied the previously articulated test of whether the fund was a mere passive investor or was also actively involved in the portfolio company’s business (the “investment plus” test).

Ordinarily, under the ERISA controlled group rule, a parent-subsidiary controlled group exists if a parent entity engaged in a trade or business owns at least 80% of a subsidiary, in which case the parent may be responsible for the subsidiary’s obligations for pension funding, multiemployer plan contributions and withdrawal liability, and other benefit liabilities. Even though the private equity funds in this case were found to have been engaged in a trade or business, potentially rendering them part of a controlled group, neither met the 80% control test. Nonetheless, the court determined that the parent equity funds operated together as a single parent entity, so that they collectively should be treated as a joint venture parent of the debtor and responsible for the debtor’s pension obligations. The court pointed to the fact that the funds coordinated their ownership and management of the portfolio company, were jointly engaged in a trade or business, and otherwise effectively operated as a single entity but were arranged to avoid 80% ownership by any one fund. The court pointed to an overriding principle in ERISA and the multiemployer rules that an entity should not be able to rely on a formalistic arrangement of ownership to avoid multiemployer liabilities.

The case confirmed that a private equity fund may be treated as engaged in a trade or business for purposes of determining whether it is part of a controlled group of entities under ERISA and the Internal Revenue Code. Of more importance, the decision ignored the formal 80% test for parent-subsidiary controlled groups, taking a position that the substance rather than the strict details of the ownership should control whether a parent entity is responsible for its subsidiary’s pension obligations where the facts compel that result.

The immediate impact is on private equity funds. If a fund owns 80% or more of a portfolio company, the fund should assume that a pension creditor of that portfolio company will make the argument that the private equity fund is engaged in a trade or business and is responsible for the portfolio company’s liabilities. Further, two or more related private equity funds could be treated as collectively liable for a portfolio company’s pension liabilities if the arrangements appear to have been coordinated to avoid responsibility for the pension liabilities. The relationship of ownership and effective control by private equity funds of portfolio companies must be reviewed.

The holding in Sun Capital Partners III LP also has potential long-term implications for all ERISA plans maintained within groups of affiliated companies, because the determination of controlled groups may change. That could significantly affect coverage, nondiscrimination, funding and other rules under single-employer pension and 401(k) plans. Employers that maintain plans within complicated controlled groups should review their controlled group analyses to confirm that the Sun Capital Partners III LP case doesn’t change their conclusions.

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